What Is Equity Compensation?

Equity compensation is a form of non-cash payment offered to employees by employers as stock options. Equity compensation is also referred to as stock compensation or shared-based compensation.

Why Is Equity Compensation Important?

There are three reasons that highlight the importance of equity compensation:

  • Attract top talent. Not all applicants expect only cash compensation from their next employer. This is a common misconception of some recruiters. It is more effective to attract top talent by sharing information about the total compensation statement, including non-cash compensation. Some types of equity compensation, like performance shares, are tied to an employee’s performance, so they are an excellent motivator for intrinsically motivated employees.
  • Increase retention efforts. An organization’s human capital is its most valuable asset, so it is essential that leaders and managers focus their efforts on retaining employees. When organizational leaders establish guidelines for stock options, they include reasonable vesting periods, which are generally four years. During the vesting period, as employees cannot yet benefit from stocks given to them by the company, they are more willing to stay for at least that time period, thus increasing retention. Though employees benefit the most when they have access to their vested stocks, organizations also benefit from the reduced costs associated with turnover.
  • Long-term financial goals. Employees receive significant financial gains when they decide to cash out their shares from the company after they have vested. They can use the proceeds from selling company stocks to pay off debt, invest in retirement accounts, save for an emergency, or reinvest in stocks or mutual funds. Employees use their stocks as a key component in their financial planning, so there’s no question about its importance to them. Non-cash payment is just as or even more valuable to employees’ long-term financial goals.

How to Know if Your Company Should Provide Equity Compensation

Before organizations decide to offer equity compensation to employees, there are several factors that must be considered.

Preserving Capital

Equity compensation options help organizations improve their cash flow, as non-cash compensation may offset the need to pay employees high cash salaries. Sometimes companies need to preserve capital to adequately fund operations and it is helpful when they aren’t offering large salaries or waging cash compensation bidding wars with competitors. This practice is more common in startup environments, but may occur in any organization seeking to increase their cash flow.

Highly Competitive Industries

It is challenging to find the right talent in competitive job industries as applicants tend to take the job with the highest cash compensation. Equity compensation is an effective way to diversify compensation options and remain competitive while attracting key talent. Highly competitive industries include finance, medicine, research, or technology. Offering both cash and non-cash compensation is crucial to maintain a competitive advantage as an employer regardless of the industry.

Building an Employer Brand

If organizations hope to be the employer of choice for top talent, their brand needs to be recognized and coveted by both active and passive job seekers. If the organization is retaining and continuously attracting top talent with their equity compensation packages, soon their brand will begin to improve. Current employees will share compensation information on platforms like Glassdoor and LinkedIn to inform other job seekers. Equity compensation is an important component of employee value proposition (unique benefits employees receive for the skills they bring to the company), a key contributor to employer branding.

Types of Equity Compensation

There are numerous ways an organization can provide employees with equity in the business. The most common types are stock options, restricted stock units, employee stock purchase plans and performance shares.

Stock Options

A stock option is an employee benefit that allows them to purchase shares in the company at a certain price for a specific time based on a signed agreement with their employer.

Restricted Stock Units (RSUs)

With restricted stock units, employees are given shares in the company by their employers but can only benefit after certain conditions are met. Employees receive RSUs through a vesting plan which outlines that they must achieve specific performance goals or be with the company for a specific period.

Employee Stock Purchase Plans (ESPPs)

An employer stock purchase plan is a program that allows employees to use payroll deductions to acquire shares in their company at a discounted price of up to 15%.

Performance Shares

Performance shares refers to a form of stock compensation given to managers and executives as an incentive only when certain company-wide performance goals are met.

How to Determine How Much Equity Compensation to Give to Employees

Offering equity compensation can be extremely challenging for organizations, so it is imperative that leaders take the necessary steps to select the correct plans to offer employees. Below are recommendations to follow when offering equity compensation to employees:

Step 1: Create an Option Pool

An option pool helps determine the amount of equity the company is willing to reserve for employees. This is important because if stocks are not correctly calculated, organizations run the risk of having less ownership of the company. It will also pose a challenge when trying to attract investors or buyers. As employees are hired and are given stock options, monitor the shares in the option pool so only the agreed upon amount of equity is being distributed. Having a capitalization table is an effective way to calculate shares usage, as this shows everyone in the organization who owns shares and the amount or percentage.

Step 2: Determine Stock Options to be Offered

After determining the option pool, decide the type of equity compensation that will be offered to employees. Will the organization only use one type of stock compensation or multiple? For example, will managers and executives only be eligible for performance shares while entry-level and associate level employees receive stock options?

Step 3: Confirm Vesting Period

Establishing a vesting period provides clarity for employees as to when they start earning shares. The standard vesting period is often four years with a one-year cliff. In this standard plan, employees would need to work for one year to earn any shares. Vesting schedules are flexible based on the needs of each organization. Some organizations may have a shorter vesting period as a strategy to attract top talent. Once a vesting schedule is created however, it must be followed by both parties.

Step 4: Prepare Contractual Agreements

Partner with your legal department or a lawyer to create contracts with eligible employees. Relevant information to include in these agreements are vesting schedule, a buy-sell agreement, number or percentage of shares, and expiration dates. Including this information in contracts protects both the company and employees because clear guidelines are established.